Excerpted and adapted from an article by David R. Johanson, Esq.

As you may have read, one of the most powerful tax and business succession planning tools available to shareholders of a closely held company is the ability to sell stock to a trust created pursuant to an employee stock ownership plan (ESOP) and defer or permanently avoid taxation on any gain resulting from the sale. Careful planning is, however, extremely important.

ESOP Feasibility Study

Assuming that the advantages of an ESOP appeal to the owner of a closely-held business, the first step is a feasibility study, which tells the owner whether the characteristics of the company and his or her circumstances are such that he or she is a good candidate for a sale to an ESOP trust. This feasibility study should involve one or more conversations with a qualified employee ownership attorney or a full-blown written feasibility analysis prepared by an attorney and/or financial consultant.

Professional, Independent Valuation

If the circumstances are such that the ESOP alternative is feasible, the next key step is to obtain an independent professional valuation of the entire company and of the portion of the company that is being sold to the ESOP trust. A valuation by an independent appraiser is one of the requirements for a transaction between an ESOP trust and an owner of the company that establishes the ESOP. Under the Employee Retirement Income Security Act of 1974, as amended, the ESOP trust cannot pay more than fair market value for the company stock that it purchases from the selling shareholder. The independent appraisal is used by the ESOP fiduciary (a board of trustees, an administrative committee, or an institutional trustee) to ensure that the ESOP trust does not pay more than fair market value for the company stock, as determined as of the date of the sale. The ESOP fiduciary must conduct the proper due diligence to make this determination in good faith.

The ESOP plan document and the ESOP trust agreement must be designed and implemented as the valuation process progresses.

In Summary

An ESOP is a versatile financial and motivational tool that can be used by a selling shareholder and a company to obtain substantial tax benefits in selling a portion or all of his or her company to an ESOP trust. Appropriate planning, knowledgeable counsel and a fair market valuation are the critical first steps.

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